Month: May 2012

There’s been a lot of talk about Spanish 10 year bond yields rising to 7 percent. We’ve been at higher levels in 2011 but at that time the EUR/USD was trading much higher. 7 percent is a critical level because that is the rate that pushed Greece, Portugal and Ireland to beg for aid. The orange line is the EUR/USD and the white line is Spain’s 10 year bond yield. That divergence is looking ugly!

My last night in London I was having dinner with David Aranzabal and Ashraf Laidi at a very posh restaurant in Mayfair (I was with Asharf after all) and conversation turned to stories about many wealthy clients that each one of encountered over the years that managed to blow up tens of millions of dollars trading FX. Most of these people were extremely successful entrepreneurs, often self made men who started with literally nothing, to accumulate vast fortunes in shipping, real estate, construction and other business endeavors. Clearly these were capable, talented men (and they were uniformly male) yet they managed to blow up their massive accounts with alarming speed.

Why?

Our uniform answer was ego. Each one of these men battled very long odds and through sheer will power were able to succeed and bend the market to their will making fortunes in the process. Having won in such difficult conditions, they couldn’t imagine the possibility of losing and therein lie their demise.

In real life you can often bully your way to the top. But in trading you cannot. The market is always bigger and always richer than any one individual. The London Whale was only the most recent of long string of traders to discover that naked truth. Above all else trading is about the suppression rather than expression of ego. Trading is always first and foremost about being humble.

However humility is not a common trait amongst most traders. Most of us are well educated, intelligent people who have enjoyed a fair measure of success in life (we wouldn’t be attracted to the markets if we weren’t intellectually curious). But it is precisely those qualities that make us very vulnerable to failure in the markets. Stubbornness in the face of adversity is frequently necessary to succeed professionally in real life, but it is a guaranteed recipe for loss when it comes to trading. That’s why some of the smartest people often make the lousiest traders. Let’s all try to remember that the next time we battle with the FX market.

Here are the latest central bank rate cut/hike expectations. Nothing priced in for the Fed, BoE or ECB (though I expect the latter two to pull the trigger on more stimulus in the coming months).

RBA -- Investors are pricing in 125bp of easing from the Reserve Bank of Australia by the end of the year! I have been bearish the AUD but 125bp is a FAR out of line. At most the RBA will lower rates by another 75bp and more likely only 50bp by Dec.

RBNZ -- Investors are also looking for 50bp of easing from the Reserve Bank of New Zealand.

Last week I posted a Twitpic of New York city bus poster that had two pictures of the same face. On one side the face was completely battered on the other it was perfectly preserved. The tag line read, “Hit at 40 mph, Hit at 30 mph” emphasizing the point of adhering to the speed limit in New York city. The ad was stark and very effective communicating succinctly the danger of pressing your luck.

At its core the New York city bus ad was all about tipping points. Press on the gas pedal just a bit more and the result can be the difference between life and death. For me this was perfect metaphor for trading. Most traders never consider tipping points. A small hedge on your loan book can quickly transform into a massive 3.5 Billion dollar loss as JP Morgan found out last week. Even the best traders in the world never fully appreciate the deadly combination of adding to a highly levered position in an unfavorable market environment. US mere mortals in FX land make that mistake all the time.

I think the reason that most traders fall into this trap is because we mistake geometric for exponential progression. In other words we think that any additional unit of risk will simply result in one additional unit of loss when in fact the losses compound almost exponentially as they propagate not only through the new position but through the entire inventory on the books. This was the mistake of the “London Whale”, Nik Leeson, Long Term Capital and many future traders still to come.

In a recent interview with Marc Sidwell, the business editor of City AM he asked me, “What is the worst mistake a trader can make?” To which I instantly answered, “Average down into a losing trade.” It is ironic that I would say that since I am notorious for doing just that in my “junk” trading account. In fact if you look at the trade runs in that account over the past several years the story looks depressingly similar, nice runs up followed by a few swift declines that wipe out most of the equity. Essentially the account looks like a mini version of LTCM.

Until December 8th of last year. That was the final time I averaged down in my “junk” trading account. Lo and behold equity never dipped more than -2% since that time and now stands 10% higher. That’s hardly gangbuster returns, but remember I do a tremendous amount of experimental trades in that account so it’s a miracle that it up even by that much. What’s absolutely incredible is that the “junk” account trade results are testament to that New York city bus ad. Lay off the gas and you’ll stay alive in New York city traffic as well as in your FX trading account.

I often drop in on the Elite Trader bulletin boards to see what traders are talking about and this week a thread titled “Why folks lose money daytrading ES” really caught my attention. The poster “gmst” discusses the finer points of trading the e-mini S&P contract, but his insights are just applicable to the FX Market. I liked his post so much, that I am going to replicate it in this week’s column with one personal observation -- ever since I limited my daytrading to no more than 2 trades per day in my “experimental” account, I haven’t even come close to a margin call and in fact just hit new equity highs this week.

gmst

Elite Trader

Why folks lose money daytrading ES

I call this rule of 2 trades per day. Newbies or struggling ES traders, do not take more than 2 trades per day, doesn’t matter if you win both or lose both how many points you made or lost. This rule has many benefits:

1. Since you are a struggling trader, so it means on average you are losing money or are just breakeven while trading ES. Taking less number of trades per day first means a slower burn rate. So you prolong the time before your capital falls to zero and this added experience increases the odds to eventually succeed at ES.

2. If you are open to take multiple trades every day (say 6-15 or even more round-trips per day), by simple logic -- you would be reversing your position multiple times. Do you know why this conclusion follows?

HINT: Answer this: When are ‘struggling traders’ going to reverse their position? Answer is: Note, by definition you are a struggling trader, so chances are more often than not, you would find your trade in a losing position and thinking that you are wrong on direction, would reverse.

As soon as you reverse, there is a decent chance that price will mean revert and you would find yourself again underwater, thus setting up for reversing again. Vicious circle. Can you see the point? If not, re-read and absorb. This is an important point.

3. Also,being limited to taking only 2 trades per day, you will learn to sit on your butt with your hands tied behind your back, waiting for that opportunity when you are very sure that you see a trade (be it for 1 point or 6 points). This sitting on your hands will teach you patience and result into higher quality of trades.

Above is a generic post applicable to almost all instruments (not only ES) but it is an important post and its easy to underestimate its importance. Struggling traders -- you should listen carefully. You will benefit. Good luck.

Here is amazing fact. Peter Lynch the legendary head of the Magellan fund made 35% per year running money during his tenure, yet most of the retail clients of Fidelity lost money despite his amazing record. Why? Because most human beings are inveterate performance chasers. They buy when money managers are hot and sell when they are cold effectively destroying any chance of building wealth in the long run.

Ironically enough most traders do the opposite. They double up on buys that have cratered and add compulsively to shorts that are running away from them. A UK publication recently asked me “What is the most important lesson you have learned as a trader?” Buy high and sell higher. Sell low and sell lower. I answered. Yet most traders will never do that.

This, I believe is the primary reason why making money in the market is so hard. To succeed we need to hold two diametrically opposite ideas in our head. As investors we have to dollar cost average into our managed funds accounts. As traders we need to buy strength and sell weakness and quickly get out if the trend turns. In short, we need to learn to chase price, not performance. Yet whether we are a 5000 dollar retail piker or a 50 Billion dollar pension fund we all continue to make the same mistake.

Understanding this one simple irony about the human condition will go a long way towards making all of us much smarter market participants.

There is a very old saying in the stock market that goes “Sell in May, and Go Away.” This pertains to the notion that investors should cash in on their investments this month and take the summer off because June, July, August and September have traditionally been some of the worst months in the equity market.

Over the past decade, this adage has held true. If you were to sell the S&P 500 at the end of May, you would have avoided an loss over the past 10 years. For the EUR/USD however you would have lost out on a gain but selling USD/JPY in May would have been a great idea because the currency pair fell steeply between June and September.

Looking beneath the hood however, the decision to sell in May and go away for the summer is not so easy for currency traders because if you did so in 2009 and 2010, you would have missed out on big gains in the EUR/USD. Between June and September of 2009, the EUR/USD appreciated more than 3 percent and in 2010 it rose nearly 11 percent.

This year, there is a reasonable chance that stocks could continue to fall, leading to more risk aversion in currencies because US data has been mixed and central banks are returning to easier monetary policies. However following seasonality without following stories blindly would be a big mistake.